Does Size Matter In Investing, or What’s Your PRR?

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Correction: The original version of this column suggested you could measure your “behavior gap” by comparing your personal rate of return (PRR) to the performance of your underlying fund. This is incorrect, and I’ve rewritten the column to reflect my mistake. I apologize for the error. Thank you to The Finance Buff for gently pointing it out.

How are your investments doing?

I don’t know you personally, but judging by the available data, I have some unflattering guesses:

1. You have no idea how your investments are doing.

2. If you think you know, you’re probably overestimating your performance by several percentage points.

Here are the sorry facts. First, most investors behave so badly, we make Lindsay Lohan look like a choirgirl. Every year, DALBAR publishes a study showing the performance of investors compared to their mutual fund investments. And every year, investors earn much less than they should, because we’re like jittery chihuahuas jumping in and out of the hot asset class of the moment. Bonds are going up? Let’s buy in! The stock market is tanking? Quick, get out! This kind of behavior costs us several percentage points of return, on average, per year. Over a lifetime of investing, that adds up to a lot of dog food.

Certified financial planner Carl Richards calls this the “behavior gap.” The problem is, nobody wants to believe they are that guy. We’re all the life of the party and above-average investors. “The research shows, if you ask people how well they’ve done, their estimate of their own returns isn’t even in the ballpark with their actual results. They’re not even close,” says Larry Swedroe, chief of research at Buckingham Asset Management and author of the Wise Investing series.

Want some numbers? In a 1997 study published in the Journal of Financial research, investors overestimated their performance by 3.4 percentage points. In related news, I think I can beat Mike Tyson.

Getting personal

Most comparisons between investors’ return and the return on their underlying investments relies on a formula called internal rate of return (IRR) or personal rate of return (PRR). The idea is that you can compare your own return to a market benchmark and see whether you’re actually beating the market.

To calculate your PRR, you need to know how each of your contributions (monthly investments, stock purchases, etc) performed over the time you held it. If you’re saving for retirement and putting away $500 a month, to calculate your PRR you’d have to consider each $500 separately, look up its return (how many shares did you buy for that particular $500, and what are they worth now?), and average them all together. If you buy multiple stocks or multiple funds, it gets that much more complicated.

That’s why, if you’re lucky, your brokerage web site or 401(k) statement will display your personal rate of return over several periods (1 year, 3 years, 5 years). Vanguard, for example, offers the feature to all customers, and it covers everything: taxable accounts, stock trades, 529 plans, and retirement accounts. Fidelity offers it to customers who trade frequently (over 10 times per month) or have over $250,000 in assets, and prints it on 401(k) statements. Schwab doesn’t offer it now but says it’s coming soon. Other discount brokerages (including E*Trade and ShareBuilder) tend to show only gain or loss based on the original purchase price of the security, which is helpful but not the same as a true PRR calculation.

Once you have this number, however, what can you do with it? If you’re a regular saver like I described above, you can’t simply compare your return with the return of the underlying fund, because it’s an apples-to-oranges comparison. The fund return tells you what you would have gotten if you’d put a lump sum into the fund and let it sit there: classic buy-and-hold. But most of us, for most of our investing life, don’t invest that way. We make regular purchases or regular redemptions.

These cash flows can radically change our return.

Comparing with a benchmark

Let’s look a specific example: me. Nearly all of my investments are at Vanguard, which makes it easy to look up my personal rate of return. I’ve been with Vanguard for about four years, and my PRR over the last three years is 13.5% per year. (You know the old joke with the punchline, “I’m telling everybody”? The same principle is at work here.) Here’s how it looks:

Turning to the portfolio analysis page, I see that my assets are 85% stocks, 15% bonds. (This is not my family’s entire portfolio; my wife holds the less-risky stuff.) If I can find a fund with approximately the same allocation, I can compare. Well, the Vanguard Target Retirement 2030 fund holds 81% stocks, 19% bonds. Close enough. (This is not an exact science.) Its three-year annualized return: 1.44%.

Slam dunk! Unfortunately for my ego, this disparity between my performance and the fund performance is meaningless. It doesn’t mean I’m a skilled or well-behaved investor. It just means I was contributing regularly to my account, and the market went up at the end. If the market had gone up sharply at the beginning of the period (when I had little money in the account) and then remained stagnant for three years, I would have shown a zero or negative PRR. Indeed, if I had looked at my own PRR in March 2009, the bottom of the bear market, it would have been negative.

The PRR tells you something real: two investors who save on the same schedule (always contributing an equal lump sum on the first of the month, for example), using the same asset allocation, should have the same PRR. If one investor underperforms, he’s paying higher fees, or using a fund pursuing a different strategy.

This suggests that once you calculate your PRR, you should go out and bug your friends to tell you their PRR. You’ll be a hit at parties.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.